Of Mice And Men: The Retirement Crisis In America

by: Kevin Wilson


Never has there been a moment as fraught with danger for retirees and those nearing retirement, as exists now; the basic assumptions used in planning have broken down completely.

Social Security and Medicare benefit levels, rates of return for all asset classes, and safe withdrawal rates are all extremely uncertain; they will not conform to standard planning assumptions.

Public and private pensions have not hit their growth targets for 10 years and will not hit them going forward either; the funding shortfall will reach $10 trillion by 2030.

Low expected returns and high risk indicate the need for retirees to go defensive and seek dividend income from funds like FEZ, JOF, VNQ, IYR, DVY, HQH, SDY, VYM.

Other specialty ETFs and funds, or private equity LPs that could help with allocations include VIG, PFF, BXMX, BX, OAK, XLP, DHLSX, and TLT.

Scottish Poet Robert Burns:

Source: Nationalgalleries.org

"The best laid schemes of mice and men, often go awry." Robert Burns (translated from the Scottish)

There has never in my career been a moment as fraught with danger for retirees and those nearing retirement, as exists in the present situation. The basic assumptions of retirement planning have broken down completely over the last few years. Planners have always assumed an income, a current age, a probable retirement age, a starting investment amount, a savings rate, income tax rates before and after retirement, a Social Security benefit level, a pension benefit level or a 401(k) matching rate, a probable longevity, an expected spending need at retirement, an inflation rate, a rate of return for each asset class of investments, and a safe withdrawal rate. JPMorgan Asset Management puts out a nice piece on retirement planning assumptions and considerations every year that lays out some of the variables.

As a planner, I have done hundreds of plans using all of these parameters in time-value-of-money models with Monte Carlo simulations for investment uncertainties. But now I believe that the specific numbers for the assumptions going forward will preclude success for many, or in fact most people. Look at the projected returns for this year (as estimated by Goldman Sachs Global Investment Research) shown below, and you will see a weak but not hopeless outlook. But note that the two best expected return outlooks are from the European and Japanese stock markets, two regions where uncertainty is very high and the risk of a financial crisis is very real.

Goldman Sachs Return Forecast for 2016:

Source: Goldman Sachs Global Investment research

The actual performance from US pension funds (about 5.8% annual return) has been far below the 7.9% average target for 10 years now, as shown below by data from the blog here. This means that the average public pension fund is now funded at a level of 71.8% (as of FY 2013), according to analyst John Mauldin. They have fallen short by 28.2% just since 2001. Private plans aren't much better, coming in at 81.7% of goal, according to actuarial firm Milliman, Inc. This adds up to about a $2 trillion shortfall currently. But as Mauldin says, this is assuming an average return going forward of about 8%. Looking ahead, as discussed further below, they will likely fall to around a 50% funding level and need at least an additional $10 trillion to meet their obligations.

The determinants of portfolio performance have long been known to be dominated by asset allocation, but that may no longer work in the way it has been traditionally interpreted. That is because all asset class expected returns are collapsing to record low rates as a direct result of the imbecilic ZIRP and NIRP experimentation by central banks around the world. Currently, $7 trillion in sovereign bonds are priced at negative yields, and that amount is climbing steadily. This is a disaster for savers and retirees.

Source: Analytic401k.com

When we look ahead to see what expected returns are likely to be going forward, we are met with horrifying prospects. Virtually all analysts using rigorous historical data are projecting low to negative returns for stocks, bonds, and cash. This is in part because we have pulled forward stock returns with artificial market stimulation via the central banks. It is also in part because future returns for bonds and cash under a combination of ZIRP and NIRP are also going to be very low, or even negative.

Forward US Stock Returns Using Shiller's CAPE:

Source: Valuewalk.com

Forward US Bond Returns Based on Valuations:

Source: Valuewalk.com

John Mauldin has nicely summarized the problem in a series of articles over the last two years (see especially: "Someone is Spending Your Pension Money," 10/24/2015, and "ZIRP and NIRP: Killing Retirement as We Know It," 2/28/2016). Below is a list of possible planning assumptions under current and projected realistic conditions for hypothetical cases, using my own and some of JPMorgan's and Mauldin's assumptions as input:

Table 1: Current Retirement Planning Assumptions:

Parameter Model 1 Model 2 Model 3
Current Age: 40 50 60
Retirement Age: 62 66 70
Longevity: 87 87 87
Income: $100k $100k $100k
Starting Invmt: $200k $300k $400k
Savings Rate: 5% 5% 5%
Tax Rate
(After Ret.): 20% 20% 20%
Pension Level $0 $0 $0
401k Matching: 10% 10% 10%
Exp. Spending: $60.0k $65.6k $71.7k
Inflation Rate: 2.25% 2.25% 2.25%
Stock Returns: 3.70% 3.70% 3.70%
Bond Returns: 2.00% 2.00% 2.00%
Cash Returns: 0% 0% 0%
60/40 SWR: ? ? ?

The 60/40 stock/bond allocation Safe Withdrawal Rate is left blank because it is meaningless under present (severe) conditions. What is surprising is how heroic the assumptions would have to become in order for any of the three scenarios listed above to work out. For example, savings would have to soar to 4x the assumed rate or higher, and retirement age would have to be deferred until later. Almost no one will be able to do it without major sacrifices. The only way out would be to consistently outperform expected returns using something like liquid alternatives; however, if Bill Gross is right, all asset class growth rates are going to zero anyway, so any advantage will be short-lived.

The crux of the problem then is the low expected returns on all types of investments, as discussed briefly above and mentioned by many other analysts. As a consequence, the average person must either withdraw much less from their investments in retirement than they actually will need (i.e., accept a lower standard of living), or as mentioned above, retire significantly later than planned or save a multiple of what was assumed above. National data suggest that the average investor has been chasing yield in a vain attempt to make up the difference through investment magic. Unfortunately, yield chasing doesn't end well historically, and there are already signs that it is failing now, as shown by the BofAML chart below:

This is all bad enough, but then on top of this, we have the serious funding problems at pensions throughout the world (already mentioned). And in our Social Security and Medicare programs in the US, we face shortfalls within a few more years. Social Security spent $70 billion more than it took in last year, according to Jed Graham of Investor's Business Daily. The most recent CBO projections on the Social Security Trust Fund indicate a shortfall of $395 billion by 2026, and in 2029 the current $2.8 trillion Trust Fund balance will have fallen all the way to zero. But the Social Security Disability Insurance Fund will run out of funds this year, and will continue to operate only because the operating budget is being supplemented by borrowing from the main Social Security Trust. So the actual time left until funding runs out for regular Social Security retirement benefits may be much shorter than the 13-year figure used by the CBO. Due to demographic trends and insufficient funding, spending on Social Security will exceed $1.5 trillion by 2029, according to the blog here. There are many proposals for reform or for fixing the shortfall, but no meaningful action can occur until after the election.

Medicare is also on a path to insolvency if nothing is done to reform the system, according to Sean Williams of The Motley Fool blog. The Medicare Hospital Insurance Trust Fund has already slipped into deficit and will potentially hit a zero balance in 2030 (best case) or as soon as 2022 (worst case). Prescription drug costs alone rose 13.6% last year. The average male is receiving Medicare benefits worth 2.95 times what he paid in, and the average female is receiving benefits worth 3.39 times what she paid in. These numbers are expected to worsen over time. One way or another, either by raising taxes or lowering benefits or reducing future costs, Medicare reform is going to have to be done, and soon.

Medicare Spending vs. Other Programs (%GDP):

Source: Noahpinionblog.blogspot.com, Heritage Foundation

Millions of people in the US have made retirement plans and are acting to achieve their goals. Millions more are living paycheck to paycheck and will likely only have Social Security and Medicare. But a combination of financial, tax, budget and demographic factors are likely to make the job much tougher for most, and impossible (under current realistic assumptions) for millions. What is to be done to resolve this terrible dilemma? I believe that all of these problems can be solved. As a great movie character (played by Anthony Hopkins in The Edge) said in a very tight situation involving (appropriately) a marauding bear, "What one man can do, another can do."

We need to hold our leaders accountable and demand that Social Security and Medicare be permanently fixed via meaningful reforms. It was done in 1983 (for Social Security), and it can be done again. Medicare is tougher but healthcare reform of a sort passed in 2010, and a reform of Medicare could also be done. It would be nice if healthcare costs could be reduced into the bargain, and I'm sure that a bipartisan, permanent fix of Medicare could and should include this. Assuming that we fix these things, which will happen once it can no longer be avoided or delayed, then at least the Social Security and Medicare parts of retirement planning, or what I would call the bedrock, will be stable and reliable going forward, even if they are somewhat reduced in their benefit levels. This is not a pipe dream; we have done this before and will absolutely get it done again, under the right leadership.

With respect to the problem with future investment returns, there are two or three ways to look at the problem. I would first consider a sort of retirement plan triage, in which we act on the most urgent issue first. That would have to be capital preservation. Many analysts expect a major market pullback (35-50%) at some point due to extreme overvaluations of stock indexes, especially in the US. Given the daunting size and range of foreign market risks right now, diversification may be pretty difficult to pull off. And correlation generally goes to 1.0 when the US market tanks anyway. I proposed a simple model portfolio in a previous paper (shown below) that would have done well in 2008-2009, based on back-testing. This Radical Allocation Model uses only four defensive holdings: 1) Diamond Hill Long/Short Fund (MUTF:DHLSX) 20%; 2) Consumer Staples Select Sector SPDR ETF (NYSEARCA:XLP) 30%; 3) iShares 20+ Yr. Treasury Bond ETF (NYSEARCA:TLT) 40%; and 4) Cash 10%. Ten-year back-testing using Morningstar's database indicates a maximum hypothetical drawdown of about 11% in 2008-2009, with a yield of 1.88% and annual returns over the 10 years that beat the S&P 500 by 1.85% annually (for what it's worth). Remember though the numerous caveats about back-testing, such as assumed dividend reinvestment, index survivorship bias, additional advisory costs excluded from calculations, and of course past performance is not predictive of future returns.

Source: Blue Water Capital Advisors

The second major issue is income from the investments. With S&P 500 yields at a low level around 2%, certain foreign markets look better from a yield point of view, as do certain US sectors. For example, high-yielding European stocks (SPDR Euro Stoxx 50 ETF (NYSEARCA:FEZ)) currently produce a 3.18% yield, and certain Japanese stocks (Japan Smaller Capitalization Fund (NYSE:JOF)) currently produce an 8.97% yield. Publicly-traded REIT ETFs like the Vanguard REIT Index ETF (NYSEARCA:VNQ) and the iShares U.S. Real Estate ETF (NYSEARCA:IYR) produce yields of 4.31% and 4.16%, respectively, but are quite volatile. However, a whole range of individual stocks have been beaten down enough to have very good yields. Some of these are fundamentally sound and should be considered in trying to boost income.

A number of ETFs containing such stocks are available and relatively easy to use, such as the iShares Select Dividend ETF ((NYSEARCA:DVY); yielding 3.5%), the Tekla Healthcare Investors CEF ((NYSE:HQH); yielding 9.26%, but highly volatile), the SPDR S&P High Yield Dividend Aristocrats ETF ((NYSEARCA:SDY); yielding 5.73%), and the Vanguard High Dividend Yield ETF ((NYSEARCA:VYM); yielding 2.74%). Sector and specialty ETFs like the iShares U.S. Preferred Stock ETF ((NYSEARCA:PFF); yielding 5.91%) and the Nuveen S&P 500 Buy-Write CEF ((NYSE:BXMX); yielding 7.95%) can be used in your allocation to boost yields a bit. For those able and willing to invest in MLPs, LPs, or Royalty Trusts, which generate K-1s and can't be put in qualified accounts like 401(k)s or IRAs, there is a wide range of choices (e.g., Blackstone Group L.P. (NYSE:BX); Oaktree Capital Group, LLC (NYSE:OAK)), but all of these are highly volatile however.

Three-Year Chart for S&P 500 (SPX; red) vs. the SPDR S&P High Yield Div. Aristocrats ETF (SDY; blue):

Source: Blue Water Capital Advisors

The third major issue is growth. This is going to be problematic for the indexes, as already discussed, but there will be individual stock plays that do well at any given time. You could try your hand at picking those, or you could just buy a small allocation to a growth-oriented ETF or fund, such as the Vanguard Dividend Appreciation ETF (NYSEARCA:VIG). In the coming months, these stocks are likely to be risky, but longer term, they will provide good exposure to the dividend growth stocks.

If you wanted a less defensive portfolio than the Radical Allocation Model shown above, you could modify both the stock and bond sides of that model using the various securities mentioned above to generate a Moderate Allocation Risk Model with components of your own choosing.

Disclosure: I am/we are long TLT, HQH, VYM, PFF, BXMX, BX, OAK, VIG.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks or other securities mentioned or recommended.